prudential framework

The final texts for the Investment Firm’s Regime (both regulation and directive) are set to be agreed this Autumn and published later this year. The Investment Firm Regime (IFR) is set to come into force in Q2 of 2021 which, as many thought it would be delayed until after European Parliament resumed after the European elections is earlier than expected. There are still several places in the regulation where the national competent authorities (in our case the FCA) are given discretion about how they wish to apply the rules. This together with complication of Brexit means it is still difficult for UK firms to know with certainty how the new rules will affect them. Regardless of what happens in Europe, given how much involvement FCA have had in the proposals, they have said they will issue their consultative paper on how they intend implementing IFR in the Autumn.

The new rules establish a simplified prudential framework for non-banks and the new regulation should result in a more proportionate and risk-sensitive rules for investment firms. Under these proposals, the vast majority of investment firms in the EU would no longer be subject to rules that were originally designed for banks. At the same time, the largest and most systemic investment firms would be subject to the same regime as European banks.

Who is in scope?

The new rules bring in all firms with MIFID activities including firms not currently subject to EBA regulation such as exempt CAD and BIPRU firms.

We set out below notable changes to previous versions of the investment firm regime.

Firm classification changes

Firms are still divided into three classes but the names and some of the thresholds have changed.

  • Systemic investment firms (previously called Class 1 firms) are firms which carry out certain bank-like activities (i.e. underwriting and dealing on own account) and have assets over €15 billion (threshold decreased from €30bn). These systemic firms remain subject to the Capital Requirements Regulation (CRR) and those with assets over €30bn will be supervised by European Central Bank (ECB).
  • For larger non-systemic firms (previously called Class 2 firms), capital requirements will be the higher of a permanent minimum capital level, ¼ of fixed overheads or the sum of a set of risk factors (K-factors). Included in this category is any firm who either:
    • Holds client money or safeguards client assets;
    • Holds assets under management (AUM) (which includes assets under management and ongoing advice basis) over €1.2bn;
    • Trades financial instruments;
    • Has client orders over 100m per day for cash trades or 1bn per day for derivatives;
    • Has a balance sheet of more than 100m including off balance sheet positions;
    • Generates annual gross revenue from investment services and activities of more than 30m calculated as an average from the two-year period immediately preceding the financial year.
  • Any firm that doesn’t meet these thresholds is a “small and non-interconnected firm” (old Class 3 firms). Minimum capital will be set as the higher of permanent minimum capital or a quarter of fixed overheads and will subject to a lighter-touch prudential regime. These firms wouldn’t be subject to the more onerous requirements on corporate governance or remuneration.

Transitional relief

Although the new regulation is looking likely to be implemented in early 2021, firms still have five years where they can use transitional relief, so it may be a while before firms see the full impact of the new regime. Different types of firms have different transitional reliefs, which makes things quite complex:

  • For firms not currently under CRR, capital is limited to two times initial capital
  • For other firms, capital is limited to either two times their fixed overhead requirement (FOR) or two times the capital they currently have to calculate

Consolidated capital and group capital testing

The final version of IFR requires parent companies to hold enough consolidated capital at group level using similar rules to those in CRR.

However, for simple groups (which the FCA still need to define) with only investment firms in the group, the parent entity can use the group capital test. This means the parent company only needs to hold enough capital to cover the book value of the subsidiaries.


  • Non-systematic firms will still need to use the higher capital calculated using K-factors or fixed overhead requirement (FOR), but some definitions or basis points used have changed.
  • The client money formula (K-CMH) now differentiates between client money held in segregated accounts, where firms need to apply 40 basis points (bp) to balances held or 50bp for non-segregated client money.
  • Trading firms with positions that are subject to clearing can choose to use the margin required by their clearing member as capital multiplied by a fixed multiplier (K-CMG) or use net position risk method (K-NPR) instead of the higher of these 2 approaches which would have meant running 2 calculations concurrently.
  • K-AUM needs firms to hold capital based on 2bp of AUM which still includes portfolios held on advisory basis. This could be problematic for investment management firms

Firms need to hold 10bp on cash trades and 1 bp on derivative trades for client orders handled (K-COH) using the rolling average of the value of the total daily client orders handled over the previous 6 calendar months.

Initial capital

To try and reduce barriers to entry, initial capital needed to operate an OTF or MTF platform is reduced from €750,000 to €150,000.


Firms with a balance sheet of greater than 100m may face quantitative and qualitative restrictions on bonuses of more than 50,000.

  • At least 40% of bonus payments must be deferred over a 3 to 5 year period
  • At least 50% of bonuses must be paid in the form of shares

However, the FCA has the discretion to disapply the provisions for firms with a balance sheet of less than 300m.

Concentration risk

The rules set out that all firms need to monitor concentration risk (K-CON) but only larger non-systematic firms need to report their concentration risk. Large exposure limits of 25% of own funds only apply to trading book positions and derivative products. Firms can exceed the limits using additional capital. If a firm does not have a trading book, there are no large exposure limits.

Reporting on liquidity risk

IFR says all firms need to have controls and procedures in place to monitor this risk and hold liquid assets but the FCA have the discretion to exempt small non-interconnected firms from holding a minimum level of liquid assets (currently set as 1/3 of FOR).

Pillar 2 capital

As the regulation is more risk sensitive, more risks should be covered by Pillar 1 capital will be covered but for risks not covered by Pillar 1 capital, Pillar 2 capital should be held. Larger non-systematic firms need to do an ICAAP and this needs to set out the nature and level of risks which they may pose to others and to which the firms themselves may be exposed. The FCA have the discretion to ask other firms for an ICAAP and it will be interesting to see how the FCA want to use this in light of their recent paper on firms maintain adequate financial resources.


Non-systemic firms will need to report key metrics quarterly and include the following areas:

  • Level and composition of own funds
  • Capital requirements and calculations
  • K factors
  • Concentration risk
  • Liquidity requirements

Small and non-interconnected firms will only need to report annually. However, the FCA can impose more frequent reporting if they so wish. 

Next steps

This is hopefully the beginning of the end for the more disproportionate parts of CRD for many investment firms. There are still several areas where we wait to see how the FCA will implement the rules and what their approach will be in light of Brexit.

For the firms who need to prepare ICAAPs now, you need to model what your capital requirements will be under IFR in the 3-year financial forecasts and stress tests. For other firms, we recommend you do a similar exercise where you model your capital requirement under IFR particularly if you are an Exempt CAD firm who has not had to calculate a fixed overhead requirement before. We can help you do all of this.

Please get in touch to find out how we can help you prepare for the changes and challenges ahead.

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